01-H68669.qxd 11/17/07 12:10 PM Page 1 1 Marginal and Absorption Costing 01-H68669.qxd 11/17/07 12:10 PM Page 2 01-H68669.qxd 11/17/07 12:10 PM Page 3 Marginal and Absorption 1 Costing The cost per unit of an item is important for • setting the selling price • valuing stocks • calculating profitability. Marginal costing The cost of an item includes only the variable costs incurred in its production. For example, Material components used and piece-rate assembly labour costs. Accounting entries As costs are incurred (e.g. materials) Dr Material Stock Account Cr Creditors (or cash) Account As materials are issued to production Dr Process 1 Account Cr Material Stock Account Direct labour costs are treated similarly. Fixed production overheads are taken straight to the P&L at the year end. Absorption costing The cost of an item includes the variable costs incurred in its production and a proportion of production overheads. Thus, absorption cost (AC) marginal cost (MC) some fixed overhead (FO) 3 01-H68669.qxd 11/17/07 12:10 PM Page 4 4 Exam Practice Kit: Performance Evaluation The fixed overhead per unit is the absorption rate (FOAR). Possible bases (methods) for sharing out the fixed overheads include • units • labour hours • machine hours • material usage. Accounting entries All variable production costs are recorded as for marginal costing. In addition, the fixed overhead per unit is transferred to the process account. This gives rise to an under or over absorption of fixed overheads; that is, a balance on the fixed overhead account which is taken to the profit and loss account. Reconciliation: marginal costing and absorption costing Marginal costing profit and absorption costing profit are the same apart from the impact of fixed overheads on stock. They can be reconciled thus Profit per AC £x Add: FO in opening stock £x Less: FO in closing stock £(x) Profit per MC £xx Comparison: MC vs AC MC AC Good for short-term decision-making Consistent with external accounting Profit not distorted by stock policy Prices must cover all costs Treats fixed costs as period costs Highlights total cost of producing Questions 1.1 A company has budgeted production of 500 X’s and 300 Y’s next year. Y’s take twice as long to make as X’s. Total fixed overheads are expected to be £102,000. Costs relating to the X are budgeted at Materials: 3,000 kg £24,000 Labour: 2,000 hours £40,000 Fixed overheads are to be absorbed on an hourly basis. 01-H68669.qxd 11/17/07 12:10 PM Page 5 Marginal and Absorption Costing 5 In addition to the above some material normally goes to waste, this is expected to amount to 10% of materials purchased. What is the absorption cost per unit of X? A £225.52 B £226.05 C £260.30 D £260.83 (4 marks) 1.2 A company’s production and sales were budgeted at 300 units. Actual production was 315 but sales were only 295. The marginal cost profit was £ £ Sales 64,900 COS Materials 15,750 Labour 15,750 31,500 Closing stock 2,000 29,500 35,400 Fixed overheads 9,000 Net profit 26,400 All costs were in line with expectations. There was no opening stock. What would the under/over absorption of overheads have been if the company had used absorption costing? A £150 Under absorbed B £150 Over absorbed C £450 Under absorbed D £450 Over absorbed (2 marks) 1.3 A company is considering improving its quality system leading to an improved repu- tation and eventually a higher selling price. Its current costs are shown below: Old system New system Total demand 3,600 units 3,600 units Defective production 20% 10% Labour cost per unit produced £35 £43 Total material per unit 3.2 kg 3.5 kg Price per kg of material £3.20 £3.95 Overheads £18,000 £29,560 01-H68669.qxd 11/17/07 12:10 PM Page 6 6 Exam Practice Kit: Performance Evaluation Which of the following is closest to the increase in selling price needed to justify this change? A £3.20 B £9.80 C £11.40 D £15.00 (4 marks) 1.4 A company budgeted to produce and sell equal numbers of units. In fact production was above budget whilst sales were below budget. Which of the following statements about marginal costing and absorption costing profits is most likely to be true? A absorption costing profits will be higher than marginal costing profits B absorption costing profits will be equal to marginal costing profits C absorption costing profits will be lower than marginal costing profits D absorption costing profits could be higher or lower or equal to marginal costing profits (2 marks) 1.5 The following are claimed to be advantages of marginal costing over absorption costing. (i) Marginal costing avoids arbitrary sharing of costs. (ii) Marginal costing is better for short-term decision-making. (iii) Marginal costing avoids profit distortions due to stock fluctuations. Which of these claims are substantially true? A (i) and (ii) only B (ii) and (iii) only C (i) and (iii) only D all of them (2 marks) 1.6 The following details have been extracted from the budget papers of LK plc for June 2003: Selling price per unit £124 Variable production costs per unit £54 Fixed production costs per unit £36 Other variable costs per unit £12 Sales volume 12,500 units Production volume 13,250 units Opening stock of finished items 980 units If budgeted profit statements were prepared by using absorption costing and then by using marginal costing, A marginal costing profits would be higher by £27,000. B absorption costing profits would be higher by £27,000. C absorption costing profits would be higher by £35,000. D absorption costing profits would be higher by £62,000. (2 marks) 01-H68669.qxd 11/17/07 12:10 PM Page 7 Marginal and Absorption Costing 7 1.7 The following are the results of last year’s production. Budgeted overheads £8,000 Budgeted production 4,000 units Actual overheads £8,500 Actual production 3,800 units What is the over/under absorption? A £500 under absorption B £500 over absorption C £900 under absorption D £900 over absorption (2 marks) 1.8 A company’s cost card is shown below. £ Materials 10 Labour 15 Fixed overheads 8 33 Variable selling costs 7 40 Selling price 50 Profit 10 Last year 4,000 units were produced, of which 3,750 were sold. Actual fixed overheads were £28,000. There was no opening stock. Calculate the profits under marginal costing and absorption costing, and reconcile them. (5 marks) 1.9 In what situations is absorption costing more appropriate than marginal costing? Are there any situations where marginal costing is more appropriate? (5 marks) Answers 1.1 B Note that material cost given represents only 90% of total costs and must be increased by a factor of 10/9. The overheads must be shared between the products using labour hours (2,000 500 4 hours for an X and therefore 8 hours for a Y). 01-H68669.qxd 11/17/07 12:10 PM Page 8 8 Exam Practice Kit: Performance Evaluation £ Material cost: £24,000 10/9 £26,667 Per unit (£26,667 500) 53.33 Labour cost per unit (£40,000 500) 80.00 FO per unit Total hours: X Y 500 4 hours 300 8 hours 4,400 hours Overheads per hour: £102,000 4,400 £23.18 Per unit of X (£23.18 4 hours) 92.72 AC per unit 226.05 B If you simply added 10% to the material cost then it comes to £52.80 (reducing overall cost to £225.52 A). If you used units to absorb the overheads this gives £127.50 per unit (increasing over- all cost to £260.83 D). Both of these errors give £260.30 C. 1.2 D Overheads would be over absorbed since actual production was higher than budget. Remember to use production as a basis for absorption, not sales. Budgeted FO per unit £9,000 300 units £30.00 £ Absorbed (£30.00 315) 9,450 Spent 9,000 Over absorbed 450 D If you use sales to absorb then you would calculate an under absorption of £30.00 295 £9,000 £150 A. 1.3 B In the following only the workings for the old system are shown. The new system would be similar. Remember that if sales are to be 3,600 units and 20% of production is defective then only 80% of production is available to be sold. Total production needs to be 100/80 3,600 4,500 units. If you calculate defects as 20% 3,600 720 and total production as 3,600 720 4,320, then when you lose 20% 4,320 864 there are only 4,320 864 3,456 avail- able for sale. 01-H68669.qxd 11/17/07 12:10 PM Page 9 Marginal and Absorption Costing 9 Old system New system Total demand 3,600 units 3,600 units Defective production 20% 10% Total production required (3,600 100/80) 4,500 units 4,000 units Labour cost (£35 4,500) £157,500 £172,000 Material cost (4,500 3.2 kg £3.20) £46,080 £55,300 Overheads £18,000 £29,560 Total costs (157,500 46,080 18,000) £221,580 £256,860 Cost per unit (221,580 3,600) £61.55 £71.35 Increase in cost per unit £71.35 £61.55 £9.80. 1.4 A In this case stocks will rise and thus absorption costing will carry forward some overheads to the next period. Thus absorption costing profits will be higher. 1.5 D All of these are true. (i) Absorption costing has to share fixed costs in an arbitrary manner. (ii) Selling prices need to exceed only variable costs in the short term. (iii) Absorption costing causes profit distortions with stock fluctuations. 1.6 B Remember that profits will be higher under AC since production sales and so some of this year’s overheads will be carried forward in stock and charged against next year’s income. It is only production overheads that this applies to. Increase in stocks 13,250 12,500 750 units Extra overheads c/f 750 £36 £27,000 B. 1.7 C Always work out the absorption rate before you start an absorption costing question. Absorption rate £8,000/4,000 £2 per unit Total overhead absorbed £2 3,800 units £7,600 Total amount spent £8,500 Under absorption £8,500 £7,600 £900. 1.8 Remember to value stocks correctly: include the fixed overheads only in absorption costing. Marginal cost £25, absorption cost £33 01-H68669.qxd 11/17/07 12:10 PM Page 10 10 Exam Practice Kit: Performance Evaluation Unit MC AC £ £ £ £ £ Sales 50 187,500 187,500 COS Materials 10 40,000 40,000 Labour 15 60,000 60,000 FO 0/8 – 32,000 100,000 132,000 Closing stock 25/33 (6,250) (8,250) 93,750 123,750 93,750 63,750 FO (28,000) Over absorption 4,000 65,750 67,750 Selling costs 7 (26,250) (26,250) Profit 39,500 41,500 Reconciliation £ Profit per AC 41,500 Less: FO in closing stock (£8 250 units) (2,000) Profit per MC 39,500 1.9 Absorption costing is more appropriate in the following situations. • Long-run pricing. In the long run both marginal costs and overheads need to be covered, using absorption costing ensures this will be so. • Financial accounting. The standardisation of external reporting requirements requires that a reasonable proportion of overheads be included in stock valuations. Many companies want the external and internal accounts to reveal the same level of profits. Where there is only one product the overheads are clearly attributable to that product and the overhead per unit figure is fairly non-controversial. Marginal costing may be more appropriate where stock building is to be discouraged. This is because absorption costing tends to boost reported profits when stocks rise, encouraging managers to stock build. Marginal costing is also more appropriate for short-run pricing decisions since any selling price that covers the marginal costing leads to an increase in contribution and hence profit.
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